Undergraduate Economist

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The Macroeconomics Underlying the Economic Survey of India 2013-14

Posted by Alex M Thomas on 10th November 2014

This blog post critically evaluates the first two chapters of the Economic Survey of India 2013-14 in order to get a sense of the macroeconomic theory underlying it. [This blog has assessed previous ones for the years:2012-13,2009-10;2010-11;2011-12.] What conceptual framework does the Economic Survey adhere to, implicitly and/or explicitly? This is of significance not just for those interested in theory but also for those who want to understand how economic policies are formulated. Attention will be mainly divided among the following macroeconomic themes: (1) role of investment in economic growth, (2) labour market flexibility and economic growth, (3) policies emanating from (1) and (2), and (4) the overarching aim of economic policy.

I

It is well-known and widely accepted that investment, be it private or public, is necessary for economic growth. By investment, we primarily refer to additions to fixed capital – machinery, tools, storage facilities, transport equipment, etc. Investment in education, health and environment should also be included, for they expand the productive capacity of the economy in the long term. Two questions may be posed now. First, what is the source of investment? Second, what ensures that the growth in productive capacity will be matched by an equivalent growth in demand?

Prior to the path-breaking work of Keynes, it was widely believed that investment is savings constrained and that saving and investment are equilibrated through variations in a sufficiently sensitive interest rate. Keynes convincingly argued that investment is not savings constrained, rather, it is finance constrained. Moreover, he demonstrated that it is activity levels (output and employment) which equilibrate saving and investment, and the causation runs from investment to saving. This is the principle of effective demand, also to be found in the work of the Polish economist Kalecki. The Economic Survey adopts the pre-Keynesian view, which, not surprisingly is still around, embedded in the neoclassical school of economics – the dominant school in economics teaching and publishing. This marginalist idea of saving-investment equilibrium is mirrored by the market equilibrium for ‘capital’ – the demand for and supply of capital is brought into equilibrium by variations in the interest rate; this is nothing but the marginal productivity theory of distribution.

Implicit in the Economic Survey is the pre-Keynesian view, an essential part of neoclassical economics. ‘…higher investment required for raising growth had to come from higher domestic savings…’ (p. 9). However on p. 11, the slowdown in investment growth is attributed to policy uncertainty, sluggish demand and high interest costs. Despite the reference to demand deficiency on the same page (on p. 13, it is acknowledged that an increase in aggregate demand has a positive impact on economic growth), the conclusion on the same page supports ‘structural reforms’ and the elimination of ‘supply-side bottlenecks’. Also, Keynes’s finance-constrained investment view is expressed when the ‘bank credit flow to industry’ is briefly discussed (p. 25); due to sluggish demand, the demand for credit was lower. [See an earlier post on the determinants of investment.]

Income earners make saving decisions (commonly referred to as households or wage earners) whereas it is the firms and entrepreneurs who make investment decisions in a decentralized economy as India. Firms also make use of their retained earnings for purposes of investment (p. 14). The intermediation of saving and investment is carried out via the banking and financial system – the suppliers of credit, so to speak. The point I wish to highlight is this: abundant savings or a low rate of interest is not sufficient for (physical) investment. There should be demand for the commodities and services produced. Also, there are no mechanisms which ensure that supply will create its own demand, famously known as the Say’s Law. At various points, it appears that the architects of the Economic Survey believe in the Say’s Law. In other words, they do believe that a growth in productive capacity will engender an equivalent growth in demand.

Policy uncertainty & investment

Policy uncertainty emanates from ‘difficulties in land acquisition, delayed environmental clearances, infrastructure bottlenecks, problems in coal linkages, ban on mining in selected areas, etc.’ (p. 11; also see p. 33). This particular statement is reflective of a view which does not take common property resources, ecosystems and environmental sustainability seriously and with caution. The uncertainty in policy vanishes when the government is clear, transparent and committed to socio-economic and environmental justice. Policy uncertainty arises from vague, untimely and arbitrary policy decisions. In fact, this approach to securing higher economic growth is inconsistent with the position adopted in the Economic Survey on sustainable development and climate change which, on paper, appears committed to environmental justice and inter-generational equity. And it is such inconsistencies which cause confusion and policy uncertainties for firms wishing to invest in India.

II

The marginalist growth theory (Solow’s growth model being the exemplar) makes use of the marginal productivity theory of distribution. Put simply, a growth in the factors of production (or factor endowments) is sufficient for economic growth. And, supply creates its own demand. According to this view, widely taught in macroeconomics courses, growth is supply-side. The impediments to growth then become imperfections in the factor markets, particular labour markets. Consequently, policy is supposed to make labour markets flexible/free/perfect so that the economy can gravitate towards the full-employment position. But, this theoretical view has been shown to be unsatisfactory given the logical problems associated with the marginal productivity theory of distribution. In addition, the creation of a just society must necessarily ensure a minimum wage for all workers sufficient for a decent living, the scope of which ought to widen as societies progress.

According to the Economic Survey, ‘[t]he inflexibility of labour markets have prevented high job creation’ (p. 30). For those brought up in the marginalist tradition, the usual culprit is the labour market. Of course, labour laws, like any other law, should be just and provide opportunities for workers to support each other given that the employers are more powerful than the workers. Also, working conditions, social security, equal opportunity across gender, caste and class and so on must be provided to the workers. This is the responsibility of institution builders – the government together with the civil society. Yes, labour market reforms are necessary: ‘changes in the legal and regulatory environment for factor markets’ (p. 31).

Reforms, unfortunately, have come to possess a single meaning in economics and politics. Reforms have come to refer to policies which make markets more free. There is no reason why reforms need to be thought of in this manner. Politics is about possibilities, and economics suggests some ways of engineering these possibilities in order to provide a decent life to all. There is nothing intrinsically good in any economic or political sense about reforms. The efficacy and goodness of reforms lies in its details.

‘Factor markets such as those for labour, land, and capital, however, remained largely unreformed. This has proved to be a constraint for growth and employment generation’ (p. 48). This statement also is very marginalist or neoclassical in nature. Moreover, one has to be cautious for the three factors of production are very different from one another. Capital refers to produced means of production – commodities and services. Barriers to entry and exit need to be reduced and firms need to operate in a competitive environment. Land is a resource which needs to be treated very carefully and on a case-by-case basis; it has immediate impacts on livelihood as well as on the natural environment. Labour market constitutes people, and there should be strong social security for workers and good working conditions.

III

Policy prescriptions include primarily supply-side measures. This is not surprising owing to the Economic Survey being fundamentally neoclassical. Investment, a component of aggregate demand, is rightly considered crucial. But, public investment is not much favoured. Investment, as noted in section I, will be revived if supply bottlenecks are removed – that is, projects get easily cleared. Policies are targeted at boosting productivity. Provision of physical and social infrastructure is of utmost importance. A market for food (reducing distortionary interventions in agriculture) needs to be created. Manufacturing must be improved.

IV

What is the central aim of these economic policies? Repeatedly, in these two chapters, the objective is to create a ‘well-functioning market economy’ (p. 29; also 26, 46). This is much needed, but the ‘reforms’ need to be socially and environmentally sensitive. Also, just as with reforms, many different configurations of a market economy are possible. This must not be forgotten, and nor should social, economic and environmental justice be overlooked. To conclude, I would add a few words to the first sentence in chapter 2: ‘The defining challenge in India today is that of generating employment and growth’ (p. 29) which is economically, socially and environmentally inclusive. These additional words make all the difference, both in terms of economics and politics.

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Posted in Economics, Employment, Government, India, Macroeconomics, Marginalist economics, Neoclassical Economics, Supply side economics | No Comments »

Misunderstanding Economic Growth and Development

Posted by Alex M Thomas on 25th August 2013

If two previous posts dealt with trying to understand how economic growth may or may not translate into development, this post goes a step behind and discusses what economic growth means. More importantly, this post examines what economic growth does not mean. The motivation for this blog post comes from Jagdish Bhagwati and Arvind Panagariya’s 2013 book titled Why Growth Matters: How Economic Growth in India Reduced Poverty and the Lessons for Other Developing Countries. Note that the following paragraphs are not intended to be a detailed review of the book; only their central premise – ‘the centrality of growth in reducing poverty’ (p. 4) – will be engaged with. The blog post, however, ends with a critical commentary on the authors’ methodology (focusing on authors’ engagement with opposing views, presentation of authors’ own arguments and referencing), as contained in the Preface, Introduction and the first three chapters. Also, no comments are offered on the data analysis present in their book.

A premise is ‘a statement or proposition from which another is inferred or follows as a conclusion.’ Bhagwati and Panagariya start with the premise that economic growth entails increase in employment opportunities and an improvement in income per person. This is also their conclusion, and forms the title of their book. They write:

Bhagwati argued nearly a quarter century ago that growth would create more jobs and opportunities for gainful improvement in income, directly pulling more of the poor above the poverty line and additionally would allow the government to pull in more revenues, which would enable the government to spend more on health-care, education, and other programs to further help the poor. Growth therefore would be a double-barrelled assault on poverty. (p. xix)

Further, they write: ‘growth helps by drawing the poor into gainful employment’ (p. 23). A simple question is sufficient to negate this view. Does the market create jobs after taking into account the abilities and skills of the poor? Of course not! If so, there would not be any unemployment or underemployment. A well-educated (and healthy) workforce is necessary so as to actually ‘gain’ from the newly created employment opportunities. [Not to forget the hardships involved in deskilling and reskilling.] And, it is not logically necessary for employment opportunities to increase when the economy grows. Jobless growth is a possibility where the surplus is not used to create further jobs; more often, it is a question of whether jobs are being created at the same pace as at which the economy grows.

By definition, economic growth entails a rise in income. But whose income? Economic growth can co-exist with the rich getting richer. Or, economic growth can give rise to stagnant wage shares amidst productivity rises. Growth can be export-led. It can be service-led. It might favour capital-intensive over that of labour-intensive technology. A rise in real GDP can happen because of a variety of reasons. It is these ‘reasons’ that one must investigate. For, it is here that we will find answers as to who the beneficiaries of economic growth are. It is to the mechanisms or processes which generate economic growth that we must attend to in order to comprehend which sector/classes/groups are losing out. For example, the nature and consequences of service-led growth will be very different from that of growth that is manufacturing-led. Bhagwati and Panagariya repeat the same fallacy, pointed out in the previous paragraph, in the following passage.

Conceptually, in an economy with widespread poverty, labor is cheap. Therefore, it has a comparative advantage in producing labor-intensive goods. Under pro-growth policies that include openness to trade (usually in tandem with other pro-growth policies), a growing economy will specialize in producing and exporting these goods and should create employment opportunities and (as growing demand for labor begins to cut into “surplus” or “underemployed” labor) higher wages for the masses, with a concomitant decline in poverty. (p. 23; see p. 43 as well)

Conceptually, in an economy with excess labour supply, labour is cheap. Bhagwati and Panagariya argue that a growing economy with cheap labour will adopt labour-intensive techniques. This reasoning assumes that an unemployed farmer or school teacher can easily and naturally be employed in a firm which exports computer parts. The authors’ views seem to indicate a gross misunderstanding of the actual economic dynamics of any society (see below as well). Moreover, one is not just concerned with mere employment, but with employment that provides good working conditions – including sick leave, maternity leave, overtime wages, etc.

‘The pie has to grow; growth is a necessity’ (p. xx). Yes, a larger surplus makes it feasible for each claimant to get a greater share, including the government. The contention is with respect to the feasibility and who these claimants are. According to Bhagwati and Panagariya, growth automatically and naturally generates higher incomes per person thereby ‘directly pulling more of the poor above the poverty line.’ Growth is not manna from heaven which everyone gets in equal amounts. It is based on definite political, economic and social institutions/processes – wage bargaining, possibilities of reskilling, mobility of labour, gender, caste, family structure, social security nets (family based or from the government) and so on. In this context, the authors rightly note the negative effects excessive licensing, government monopolies and protectionism can have on the growth of an economy (p. xii).

Given the authors’ belief in a strict one-way causation running from economic growth to development, they argue for carrying out growth-enhancing reforms first, which they refer to as Track I reforms. Subsequently, the surplus can be redistributed by the government to achieve development; this can be through transfer payments of various kinds. These are known as Track II reforms. They argue:

Track II reforms can only stand on the shoulders of Track I reforms; without the latter, the former cannot be financed. (p. xxi)

Of course, they can be financed through government borrowing and there is ample literature on the issues surrounding debt-sustainability in relation to achieving full employment. One wishes to see a more nuanced understanding of such matters.

This separation of growth from development is not just illogical and untrue, but also dangerous to public policy. Often, for purposes of economic theorising, in order to carefully study the causal relations between variables, some boundaries are drawn and certain assumptions are made. But, an import of this technique into the domain of public policy is methodologically flawed, where the abilities of individuals to seek jobs and actually work and earn (higher) incomes crucially depend on their social, cultural and economic backgrounds. In other words, while the distinction between economic growth and development might be reasonable for some purposes, in practical politics, they go together. Moreover, if the policy objective is to ensure good quality of life for all, then it must be the case that, to use the authors’ terminology, both Track I and II should be undertaken at the same time, with perhaps a greater emphasis on Track II reforms.

A fundamental error underlies the authors’ belief that ‘growth’ is an automatic process which takes place when the government lets the private players have a completely free hand, international trade is free, and capital can freely flow in and out of the country. It is this notion which makes the authors’ note that ‘Track II reforms involve social engineering…’ (p. xxi). That is, in their view, Track I reforms require no ‘social engineering’. Nothing could be farther from the truth! A ‘market’ is an engineered institution. The belief that ‘free markets’ will deliver both economic and social justice is quite easily discernible from their statements. Making commodity markets free (from both government and private monopolies) is certainly beneficial for economic growth as well as for wider socio-economic development. But, given the (historical or otherwise) arbitrariness (as opposed to ‘merit’) involved in the ownership of various forms of assets, and the tendency of markets to favour the powerful, there is always a crucial role for the government and civil society to intervene in order to ensure social justice (especially in the arenas of education and health). After all, is this not what we mean by participatory democracy?

The preceding commentary is based on a partial reading of Bhagwati and Panagariya’s book, as noted in the introductory paragraph. Their conception of growth, at best, seems superficial and at worst, they misunderstand the dynamics of economics growth as well as development. The view of ‘free markets’ generating growth with rising incomes per person is never an automatic process. It requires visible hands and is indeed social engineering. We end with a few observations on their methodology. For them, all that their critics say are myths; Part I of their book is titled ‘Debunking the myths.’ On one occasion, some of the critics, who are hardly ever named (and therefore not cited), are accused of being ‘intellectually lazy’ (p. 25; also see p. 32, p. 34, p. 35 for the unnamed critics). On the other hand, the following phrases are used for arguments in their own support: ‘state-of-the-art techniques’ (p. 31), ‘detailed state- and industry-level data’ (p. 31), ‘compelling nature of evidence on the decline of poverty under reforms and accelerated growth’ (p. 33), ‘irrefutable evidence’ (p. 37), ‘evidence…is unequivocal’ (p. 38) and ‘these authors’ superior methodology’ (p. 43). Out of the total number of references excluding data sources and reports (around 125 in number), about 37% (around 47 in number) are references to the authors’ work, either as a sole author, a co-author or as the editor of the volume. This is very striking. And, out of citations to Panagariya’s work (about 27 in number), 14 of them are newspaper articles published in the Times of India or Economic Times. It is indeed unfortunate to come across so many fundamental errors in a book like this, because growth does matter, although not at all in the way Bhagwati and Panagariya expound in their book!

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Posted in Book reviews, Development Economics, Economic Growth, Economics, Education, Employment, GDP, Government, India, Labour Economics, Macroeconomics, Markets, Neoclassical Economics, Poverty, Unemployment | No Comments »